Question

A portfolio manager decided to purchase corporate bonds with a market value of €5 million. To finance 60 percent of the purchase, the portfolio manager entered into a 30-day repurchase agreement with the bond dealer. The 30-day term repo rate was 4.6 percent per year. At the end of the 30 days, the bonds purchased by the portfolio manager have increased in value by 0.5 percent and the portfolio manager decided to sell the bonds. No coupons were received during the 30-day period.

A. Compute the 30-day rate of return on the equity and borrowed components of the portfolio.

B. Compute the 30-day portfolio rate of return.

C. Compute the 30-day portfolio rate of return if the increase in value of the bonds was 0.3 percent instead of 0.5 percent.

D. Use your answers to parts B and C above to comment on the effect of the use of leverage on the portfolio rate of return.

E. Discuss why the bond dealer in the above example faces a credit risk even if the bond dealer holds the collateral.

Answer 1

A.B.C.

Value of bond becomes		0.50%	0.30%
Total value of Bond		5000000	5000000
Finance taken	60% of total bond value	3000000	3000000
Investment by portfolio	40% of total bond value	2000000	2000000
30-day repo rate		4.60%	4.60%	per annum
30-day repo rate	per annum rate *30 / 360	0.38%	0.38%	per 30 days
Bond value after 30 days	5000000 * 1.05	5250000	5150000
Interest paid on financing	3000000 * 0.38%	11500	11500
Net profit	525000 - 5000000 - 11500	238500	138500
Rate of return on equity	Net profit / investment	7.95%	4.62%
Rate of return on debt	rate of debt	0.38%	0.38%
30 day portfolio rate of return	WACC	4.92%	2.92%

D. Effect of leverage on the portfolio is that the portfolio becomes very risky and volatile. We can see that only 0.2% change in the outcome has caused a decline of ROE from 7.95% to 4.62%.